Thursday, September 27, 2007

Distributional Impact of Bubbles?

Daniel Gross has long argued that bubbles in the long run are good for the economy despite sucking for the investors who got caught up in the bubble mania phase of an investment cycle. In an interview published by Tech Central Station today, he pulls up the example of Google being able to scale massively in 2001, 2002 off of the carcasses of dark fiber laid down at the peak of the .COM bubble and then written off. Google was able to take advantage of past investments laid down at fairly high prices and bought out cheap to build an empire... not a bad business plan if you can pull it off.

However, I digress, as I want to speculate some on the distributional impact of bubbles, which may tie into the latest go-around on income distribution figures. Here is my story and theory, and it is all speculation at this point....

Sophisticated investors and 'smart money' in a trend growth environment tend to already have significant assets and wealth under their own personal control. A guy whose primary pre-occupation is managing their own financial assets should do better on average than a low information/low knowledge 401(K) holder for instance. During the initial stages of a bubble, smart money can go in and buy assets that should be promising fairly cheaply. Retail and low asset investors lag in chasing the best returns. At this point most of the investments are reasonably sound and logical investments that early investors are getting fairly cheaply compared to future expected returns. For instance, the early money into Netscape went to developping a great browser. Early money in Pets.com went to developping a decent IT back-end etc.

As the combination of hype, outsized profits generated by either a disruptive business model, product, or less fortunately positive GIGO feedback mechanisms, lower information, and lower asset level investors start jumping in. The primary means of jumping in at this point is by buying shares on the open market, and in a bubble wave of IPOs or condo conversion projects, a massive transfer of wealth takes place between low information investors and a much more concentrated class of individuals and groups. In Netscape's case it went to a small cadre of innovators, managers and finance geeks as they cashed out fairly quickly. In Pets.com it went to bad commercials starring sock puppets.

Money keeps pouring in for a while and then the party stops as everyone realizes that either the business model makes no sense anymore OR there are no greater fools left OR both of the previous ideas. Smart money, or insider money at the very least most likely had been spending some serious time getting out of these positions for a while as they realize that there is a finite supply of greater fools available.

And then we hit a crash. Good companies with decent ideas and decent investments crater along with crappy companies... in real estate prime mortgages are taken down by localized falls in real estate as the three houses with liar loans on them down the street are foreclosed and auctioned off for 65% of their peak value.

In this process cash or at least very liquid hedges are king, and historically big money is more likely able to access liquid hedges. And then in Gross's example, companies like Google rise up from the ashes of a bust and utilize all of the boom's overcapacity at marginal operational costs instead of marginal operating costs and capital costs of construction.

In this story, Google is the beneficiary of a massive secondary transfer of wealth from the investors who got in late during the boom and could not get out near the top, and historically, the late investors are the least sophisticated investors.

I wonder and again, this is pure speculation, if the increased income inequality during the past thirty years has been (partially) the result of more bubbles and thus more transfers of wealth and income from late/mass investors to early investors and 'vulture' companies that are able to offer great value propositions on the remains of the new infrastructure created during the previous bubble.....